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While there are many tax and investment benefits to investing directly in real estate, not everyone wants to be a hands-on landlord. For those who buy a substantial amount of real estate, it’s often cost effective to hire a property manager to delegate such management tasks to. For everyone else, the most appealing option is simply to become a “pooled” real estate investor with others, through a Real Estate Investment Trust (REIT), which allows some of the pass-through tax benefits of real estate investing, but with better management economies of scale and more diversification than what most investors can feasibly access with limited dollar amounts to invest.

Under the Tax Cuts and Jobs Act of 2017, though, REITs have been afforded a new tax preference: the IRC Section 199A deduction for “pass-through” businesses, that allows for a 20% deduction of any qualified REIT dividends against that very income, resulting in an effective 20% reduction in the tax rate on REITs (where the top 37% tax rate becomes “just” 29.6% instead).

Notably, the new Qualified Business Income (QBI) deduction under Section 199A is available for direct investments in real estate as well. However, direct real estate investments only qualify for the deduction if the amount of real estate investment activity amounts to a real estate “business” (where purely passive real estate investment income may not count), and is further limited for certain high-income individuals due to wage-and-depreciable-property tests that apply to married couples with taxable income above $315,000, and all other filers with taxable income about $157,500. By contrast, qualified REIT dividends simply obtain the 20% Section 199A deduction, implicitly counting as a real estate “business” (by virtue of a REIT’s size and scale), and without any high-income limitations on the deduction!

Of course, in the end, an investment in a REIT should be evaluated by its overall investment merits, and not just its tax treatment alone. Nonetheless, for otherwise equal real estate investments, going forward, REITs will be substantially easier to qualify for the full Section 199A deduction with fewer limitations for high-income individuals, and a tax benefit sizable enough that REITs almost (but not quite) enjoy tax benefits similar to the preferences for long-term capital gains and qualified dividends. Which means at a minimum, the relative improvement of tax treatment for REITs will mean they deserve a “fresh look” from an investment perspective… along with a re-evaluation of where they should be held from an asset location perspective (given that REITs held in a tax-preferenced retirement account will lose out on the new Section 199A deduction!).

In recent weeks, there has been a flurry of proposals to potentially modify Required Minimum Distribution (RMD) obligations, from President Trump’s Executive Order, to legislative proposals in both the House and the Senate. In some cases, the proposals would provide some “RMD relief” for those who don’t want or need to take withdrawals during life, although another proposal would actually increase required minimum distributions for beneficiaries after death!

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1 PM EST broadcast via Periscope, we examine the arguments for updating the RMD rules, delve into the proposed changes from both President Trump and Congress, discuss why the media hype over “RMD relief” might be much ado about nothing, and why despite the recent discussions of RMD relief that the greater risk is still for a potential RMD crackdown (especially on stretch IRAs) in the coming year or few!

The first proposal to consider is President Trump’s recent Executive Order, which focused mainly on MEPs (Multiple Employer [Retirement] Plans), but also included a directive to the Treasury Department to update the life expectancy tables used to calculate required minimum distributions. Which is arguably overdue, as the last time the tables were updated was 16 years ago, and recent medical advances have certainly increased life expectancies since then. Which means, at least ostensibly, that there’s an increased risk that RMDs will deplete retirement accounts too quickly.

However, the reality is that life expectancy increases have not been terribly dramatic – no more than about 2 years of joint life expectancy for a 70-something retiree. Which means, on a percentage basis, the first RMD would actually decrease only about 25 basis points – from 3.65% of the account balance to just 3.4% instead – or a whopping $250 of reduced RMDs per year on an account with a $100,000 balance. And of course, the taxes due on that RMD at a moderately affluent 22% tax rate is only $55 of real tax savings. Which itself is just tax deferral (since the taxes on the IRA will still be due someday, RMD or not!).

And unfortunately, the other leading proposal for RMD “relief” isn’t much better. In the House, Congress is currently considering a package of the three pieces of legislation, colloquially know as “Tax Reform 2.0”, which mainly seek to make last year’s Tax Cuts and Jobs Act permanent, but also propose to create a new Universal Savings Account (USA) for tax-free savings (with a $2,500 per year contribution limit but no limitations on how withdrawals must be used), and more importantly for retirees would eliminate RMDs on employer retirement plans with balances under $50,000 (along with repealing the age limit on regular IRA contributions for 70-somethings who are still working to allow them to still contribute while also taking RMDs).

Yet again, while these additional RMD proposals make sense, none of them would make a material difference for most clients of financial advisors, especially when we consider that RMDs on a $50,000 401(k) are relatively small to begin with, and IRA contributions must come from earned income (and not that many 70-somethings are still in the workforce) and still may not be enough to offset RMDs anyway.

Meanwhile, what hasn’t received much attention at all is a far more important proposal buried in the Retirement Enhancement and Savings Act of 2018 (RESA), currently under consideration in the Senate, which would eliminate the stretch IRA for most non-spouse beneficiaries, who would then be subject to the far-harsher 5-year rule instead!

The bottom line, though, is simply to understand that the RMD relief proposals that have been getting the most attention lately won’t likely have any meaningful impact for most clients, while the impact from the one that would make a material difference from a planning and tax perspective would be very negative indeed! Of course, there’s no telling how long Congress will continue to kick the can down the road – proposed legislation can linger for months, or years, or “forever” before ever actually being passed into law – but the point remains that despite the recent buzz for RMD relief, the greater risk for those with sizable retirement accounts is still that RMDs may become more restrictive in the future, not less!

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In addition to having unique income-plus-appreciation-potential investment characteristics as an asset class unto itself, one of the primary benefits of directly investing in real estate is its favorable tax treatment, where capital gains are deferred until sold (and potentially further deferred with a 1031 exchange), and ongoing rental income can be at least partially offset by depreciation deductions.

In December of 2017, the Tax Cuts and Jobs Act further extended the benefits of investing in real estate by introducing a new “qualified business income” (QBI) deduction under IRC Section 199A that further reduces net rental real estate income by up to 20%.

The caveat, however, is that recent Treasury Regulations have clarified that not all direct real estate investing will actually qualify for the Section 199A deduction. Instead, investors must be able to demonstrate that they are operating a real estate “business” in order to qualify and show that either they personally, or other employees of the business, are spending a substantial amount of time actually engaged with the real estate (to differentiate a business from a mere real estate “investment” instead).

Furthermore, the QBI deduction for real estate investors may be further limited by the so-called “wage-and-depreciable property” test, which for high-income taxpayers (married couples filing joint returns with taxable income above $315,000, and taxable income above $157,500 for all other filers) typically partially or fully caps the maximum deduction at 2.5% of the original (i.e., “unadjusted”) basis of the property, plus 25% of the wages paid to employees in the business.

Nonetheless, the opportunity to deduct 20% of a real estate business’s net income provides substantial potential tax savings, making direct real estate investing even more appealing. Especially since, for those truly engaged in a real estate business with multiple properties, aggregation rules make it possible to group real estate investments together in a manner that at least eases the challenges of navigating the wage-and-depreciable-property test in the first place!

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While much of the Tax Cuts and Jobs Act of 2017 was focused on individual and corporate tax reform and simplification, one of the biggest new planning opportunities that emerged was the creation of a new 20% tax deduction for “Qualified Business Income” (QBI) of a pass-through entity, intended to provide a tax boon to small businesses that would leave more profits with the business to help it grow and hire.

The caveat, however, is that the QBI deduction was only intended to provide tax benefits for profitable businesses that hire employees, not to provide tax benefits for high-income professions who generate their profits directly from their own personal labors. As a result, the new IRC Section 199A created a so-called “Specified Service Business” classification that, at higher income levels, would not be eligible for the QBI deduction.

The challenge, however, is that the exact definition of what constitutes a “Specified Service Trade or Business” (SSTB) has not always clear, given the wide range of professional services that exist in the marketplace. In addition, as soon as the rules themselves were released, creative tax planners began to strategize about how to arrange (or re-arrange) revenue and profits to maximize the amount of income eligible for the QBI deduction and minimize exposure to the Specified Service Business rules.

In this guest post, Jeffrey Levine of BluePrint Wealth Alliance, and our Director of Advisor Education for Kitces.com, examines the latest IRS Proposed Regulations for Section 199A, which provides both important clarity to how the “Specified Service Business” test will apply in various industries, including rather broadly for professions like health, law, and accounting, but only narrowly to high-profile celebrities who may have their endorsements and paid appearances treated as specified service income but not the income from their other businesses that may still materially benefit from their high-profile reputation.

Of greater significance for many small business owners, though, are new rules that will force businesses with even just modest specified service income to treat the entire entity as an SSTB, limit the ability of specified service businesses to “carve off” their non-SSTB income into a separate entity, and in many cases aggregate together multiple commonly owned SSTB and non-SSTB business for tax purposes.

Ultimately, the new rules are only impactful for the subset of small business owners who engage in specified service business activities and have enough taxable income to exceed the thresholds where the phaseout of the QBI deduction begins (which is $157,500 for individuals and $315,000 for married couples). Nonetheless, for that subset of high-income business owners, effective planning to avoid having SSTBs “taint” non-SSTB income, or to split off non-SSTB income to the extent possible, will be more challenging than before.

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While qualified plan participants are generally required to begin taking distributions April 1 of the year following the year the plan participant turns 70 ½, the “still-working” exception delays the RBD to April 1 of the year following the year the employee retires. The motivations behind the still-working exception are simple enough (Congress anticipated that some workers would continue working beyond age 70 ½ and did not want to force these participants to begin taking distributions), however the reality is that the provision itself is surprisingly complex, containing many layers of rules that influence one another and make the determination of whether an individual is “still-working” more difficult than many would expect.

In this guest post, Jeffrey Levine of BluePrint Wealth Alliance, and our Director of Advisor Education for Kitces.com, takes a deep dive into the still-working exception, examining how an individual is (or is not) determined to be “still-working”, as well as the planning strategies that arise from the exception, such as rolling qualified assets into a still-working exception eligible plan, divesting more than 5% ownership of a company prior to age 70 ½, creating a new business after age 70 ½, and even just making sure the requirements are met to qualify for the still-working exception!

To the surprise of many, defining precisely what it means to be “still working” (e.g., 1 hour per week, 10 hours, 20 hours?) is not something that the IRS has done. However, the general interpretation based on a plain reading of the law is that, as long as the employer still considers an individual employed, that person is “still employed” for the purpose of the still-working exception (even if the ongoing work is of a relatively limited nature). However, this determination is further complicated by the fact that an employee must be employed throughout the entire year to qualify for the exception and delay RMDs past their 70 ½ year, which is defined as not having retired at any point during the year, including December 31st! So, if an individual worked every day of the year (including a full work day on December 31st), but retired on December 31st (i.e., did not come back to work at any time in the next year), then the individual would be deemed retired in that year and would not be eligible for the still-working exception during that year.

Another complication with determining whether an individual is “still working” is the exclusion of the rule for 5% owners of a business. One point of confusion is that 5% owners are not considered “5% owners” for the sake of this rule. Instead, owners must own more than 5% in order to be considered a 5% owner. A second point of confusion is that ownership according to the 5% ownership rule includes indirect ownership of stock owned by a spouse, children, grandchildren, and parents (though not siblings, cousins, aunts/uncles, and nieces/nephews). Further, the still-working exception is based on a one-time test of ownership in the plan year ending in the year an employee turns 70 ½, which actually means that those who own an increasing amount of a company after reaching age 70 ½ can own more than 5% and be considered less than 5% owners (or may own less but still are considered more than 5% owners).

Fortunately, this complexity does create planning opportunities which individuals can use to reduce (or at least delay) their tax bill. In particular, individuals may want to consider rolling other qualified into still-working exception eligible plans (as only an account through an eligible employer receives an exception from taking a distribution), divesting more than 5% ownership prior to age 70 ½ (as the test is only applied at this age), creating a new business and adopting a qualified plan after age ½ (as the new business would not have been around when an individual reached age 70 ½), or just making sure that the requirements to receive the still-working exception are met (as despite the popularity of retiring on December 31st, it may be beneficial to work at least one day into a new year).

Ultimately, the key point is to acknowledge that the still-working exception is not as straight-forward as is often believed. There is a lot of complexity in the rules surrounding the still-working exception, yet, at the same time, a lot of opportunity for tax planning as well (at least for those who have the luxury of not needing their retirement funds at age 70 ½ and who can continue to defer spending into the future)!

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The Federal government has long incentivized saving for retirement and other financial goals by offering some combination of three types of tax preferences: tax deductibility (on contributions), tax deferral (on growth), and tax-free distributions. As long as the requirements are met, various types of accounts – traditional to Roth IRAs, and annuities to 529 plans to Health Savings Accounts – enjoy at least one tax preference, often two, and sometimes all three.

For most households, these tax-preferenced accounts simply help to encourage (and tax-subsidize) savings towards various goals, and cash-flow-constrained households allocate based on whichever goal has the greatest priority. Yet for a subset of more affluent households, where there’s “enough” to cover the essential goals, suddenly a wider range of choices emerges: how best to maximize the value of various tax-preferenced accounts where it’s feasible to contribute to several different types at the same time?

Fortunately, the fact that not all accounts have the exact same type of tax treatment means there is effectively a hierarchy of the most preferential accounts to save into first (up to the dollar/contribution limits), after which the next dollars go to the slightly less favorable accounts, and so on down the line… from triple-tax-preferenced accounts such as the Health Savings Account (tax-deductible on contribution, tax-deferred on investment growth, and tax-free at distribution for qualified medical expenses expenses), to double tax-preferenced accounts such as traditional and Roth-style IRAs, to single tax-preferenced accounts such as a non-qualified deferred annuity (which is tax-deferred only). Which in turn must be balanced against even “traditional” investment strategies of simply buying and holding in a taxable account… which itself effectively defers taxes, thanks to the fact that long-term capital gains are only taxed upon liquidation.

Notably, many of the tax preferences do come with trade-offs (such as penalties for early distribution, and rules about how the funds can be spent), but for high-income earners, those limitations simply mean it will be necessary to coordinate amongst the various tax-preferenced savings accounts at the time of liquidation (and aren’t a reason to not use them in the first place).

Of course, there is still the foundational tier of savings to provide an emergency fund (and perhaps funds to promote job mobility and business startup expenses as well, which may be particularly appealing for higher income individuals), but the key point is to acknowledge that there is a hierarchy of tax-preferenced accounts – ranging from triple-tax-preferenced accounts to accounts with no tax preferences – and high-income earners can better limit their tax liabilities and maximize their growth by adhering to this hierarchy!

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For financial advisors, the new Qualified Business Income (QBI) deduction (also known as the IRC Section 199A deduction, or the pass-through deduction) presents not just many tax planning opportunities for small business owner clients, but also tax planning opportunities for financial advisors themselves as small business owners. The caveat, however, is that the 20% QBI deduction may be very limited for financial advisors, because they are classified as “Specified Service Business” owners under the new rules, and, as a result, any “high income” advisors (defined as those whose taxable income exceeds $315,000 when filing a joint return, or $157,500 when filing otherwise) are subject to a phaseout of their potential full QBI deduction.

In this guest post, Jeffrey Levine of BluePrint Wealth Alliance, and our Director of Advisor Education for Kitces.com, examines how high-income financial advisors (and other Specified Service Businesses) can utilize strategies to get the most benefit from their QBI deduction, including spinning off and renting back depreciable property, creating a PEO and leasing back employees, condensing lifetime giving via the use of a donor-advised fund, and other strategies!

The good news of the new QBI rules, and the phaseout for Specified Service Businesses (including financial advisors), is that it still takes a fairly substantial income to phase out the deduction, and for those under the income thresholds, the full QBI deduction remains available. On the other hand, because the QBI deduction phaseout is based on total household income from all sources (albeit after all deductions), even advisors who themselves don’t earn more than the threshold amount may still end out phasing out some or all of the deduction based on other income (e.g., spousal income, real estate income, portfolio income, etc.).

Fortunately, though, not all is lost for financial advisors who have entered into the QBI phaseout zone. First and foremost, advisors can look to strategies that convert the advisor’s specified service business income into “other” income derived from a non-specified trade or service business, such as by spinning off any firm-owned real estate into a separate entity (and leasing it back at fair market value), spinning off non-advisory employees and leasing them back through a professional employer organization (PEO) (as a PEO would be eligible for a QBI deduction, so long as it is not deemed an advisory business), or holding the firm’s intellectual property under a different entity and then licensing it back to the firm (as the intellectual property income may be eligible for a QBI deduction). The net result of such strategies is that the advisor’s total income is the same, but occurs by reducing the amount of specified service business QBI generated from their practice (as rent, employee leasing, etc, are deductible business expenses), while simultaneously increasing the amount of QBI generated from the separate (non-specified-service and QBI-deduction-eligible) businesses.

For those who are in the midst of the QBI phaseout zone, planning can be even more impactful, as marginal tax rates during the QBI phaseout can spike as high as 64%… which may lead advisors to increase investment into the firm (as deductions are more valuable at the higher rate!), shift income to other years (that are outside the phaseout zone), or potentially even cut back on their workload (if they’re really only keeping 36 cents on the dollar before the additional impact of state income taxes!).

Ultimately, the key point is to acknowledge that high-income financial advisors (and other specified service business owners) have considerable opportunity to plan around the new QBI phaseout zone… even if their total income is within or well beyond the QBI phaseout zone! While the new rules can be a bit tricky (and strategies could shift as the IRS provides more guidance going forward), it appears that QBI strategies will be a key focus going forward, and present a considerable planning opportunity for advisors (and their clients!) to reduce their overall tax burden!

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The Tax Cuts and Jobs Act (TCJA) included the most substantial changes to the tax code that we have seen in over 30 years. The change which has garnered the most attention amongst financial advisors, though, is the new 20% deduction for Qualified Business Income (QBI). What’s unique about the QBI deduction (also known as the IRC Section 199A deduction, or the pass-through deduction) is not just the size of the deduction (as a deduction of up to 20% of certain business income is certainly appealing!) but the fact that many financial advisors themselves will be eligible for a QBI deduction, albeit subject to some “high-income” limitations that some financial advisors will need to plan for in order to avoid having their QBI deduction phased-out entirely.

In this guest post, Jeffrey Levine of BluePrint Wealth Alliance, and our Director of Advisor Education for Kitces.com, examines how financial advisors (and other Specified Service Businesses) can maximize their QBI deduction through business entity selection, including why employee advisors may want to convert to being independent contractors, why S corps may want to convert to partnerships, LLCs, or a C corp (or not!), and why sole proprietors may not need to make any changes at all.

A key to understanding the new QBI deduction is how the “high-income” phaseout works. For QBI purposes, any Specified Service Business owner (including a financial advisor) who files a joint tax return with more than $315,000 of taxable income, or an individual who files under any other status with taxable income of more than $157,500, will be considered “high-income”. And being “high-income” triggers a partial phaseout of the QBI deduction, and culminates in a total phaseout once taxable income exceeds $415,000 (joint) or $207,500 (other tax filers). Notably, since these thresholds are based on taxable income, it includes income from any sources (investment, spouse, etc.), even though the QBI deduction itself is calculated based on the business’ income.

The reason business entity selection influences an advisor’s QBI deduction is that not all compensation to an advisor (or other small business owner) is considered qualified business income eligible for the deduction in the first place. For instance, financial advisors who receive W-2 wages as an employee advisor are not eligible for a QBI deduction for those wages… which is why employee advisors may want to consider converting to become independent contractors (if their employer will allow it), as their sole proprietor income would be considered QBI. Income from partnerships or LLCs taxed as partnerships will generally be considered QBI, with the exception of guaranteed payments made to partners (which may mean advisors utilizing operating agreements with substantial guaranteed payments may want to reconsider this structure in light of QBI considerations). The good news for S corps is that so long as advisors can reasonably claim a lower salary, profit distributions (though not the wages portion) will avoid self-employment taxes and be considered QBI (although this extra incentive to push the boundary of what may be considered reasonable salary will also likely mean extra IRS scrutiny of S corp income). For C corp owners, wages again are not considered QBI, although such owners may still benefit from the newly reduced corporate tax rate of only 21%.

Ultimately, the key point is to acknowledge that business entity selection plays a key role in maximizing a QBI deduction as a specified service business owner (which includes financial advisors). And although many financial advisors (and other specified service business owners) may totally phase out the QBI deduction due to their high income, choosing the right business entity structure can help advisors preserve as much QBI deduction as possible!Read More…

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The Tax Cuts and Jobs Act brought the biggest changes to both individual and corporate taxes that we’ve seen in the past 30 years. Included in those changes was IRC Section 199A, which is a new section of the tax code that introduces a 20% deduction on qualified business income (QBI) for the owners of various pass-through business entities (which include S corporations, limited liability companies, partnerships, and sole proprietorships). Fortunately, the QBI deduction will provide big tax breaks for many business-owning clients, but unfortunately, the new deduction is highly complicated, and it may take some time before the IRS can even provide more meaningful guidance on how it will be applied. However, the reality is that the planning opportunities created by IRC Section 199A are tremendous, and practitioners are already eagerly exploring how they can help clients reduce their tax burden through creative strategies around the QBI deduction.

In this guest post, Jeffrey Levine of BluePrint Wealth Alliance shares some of his own QBI deduction strategies and considerations after the TCJA. Broadly speaking, most strategies QBI deduction strategies can be broken into the three buckets, including income reduction strategies to stay below the income threshold where the specified service business or wage-and-property tests kick in, “income alchemy” strategies for transforming income from a specified service business into non-specified service business income, and other business strategies – such as hiring more W-2 employees – which are focused on favorably characterizing business income.

Notably, within each bucket are a wide range of tactics. Business owners who could benefit from income reduction strategies can consider ideas such as planning around retirement contributions, transferring portions of ownership to various non-grantor trusts, and revisiting filing separately as a married couple. Business owners who could benefit from “income alchemy” strategies can consider spinning-off certain assets and leasing them back, creating employee leasing companies, and even avoiding marketing language that makes strong claims about a business owner’s skill. And business owners who could benefit from favorably characterizing business income may want to reduce or eliminate guaranteed payments to partners, change profit-eligible-only S corporations to partnerships, or switch from a salaried employee to an independent contractor.

Ultimately, the key point is to acknowledge that IRC Section 199A creates a tremendous number of planning opportunities after the TCJA. New strategies with QBI deduction implications will certainly continue to be developed with time and further guidance from the IRS, but even in the present, financial planners already have enough reason to reach out to business-owning clients and help them reduce their tax liabilities!

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To fulfill their intended purpose in supporting saving for retirement, Congress grants the Individual Retirement Account (IRA) certain tax preferences, from tax-deductible contributions (in the case of traditional IRAs) to tax-free growth (for a Roth IRA). But to curtail potential tax abuse, the Internal Revenue Code also limits the range of permissible investments in an IRA, and explicitly bans life insurance contracts and collectibles (and under separate rules, S corporations cannot be owned in an IRA, either).

Furthermore, because an IRA is intended to be treated as a separate tax-preferenced retirement account from the other assets of the IRA owner, the Internal Revenue Code also contains a series of “prohibited transaction” rules intended to prevent the IRA owner from using the account to enrich themselves or their family members (without actually taking a taxable withdrawal). The prohibited transaction rules cause adverse tax consequences for the IRA if it engages in such prohibited transactions with any “disqualified person”, which includes the IRA owner themselves and his/her immediate family members (as well as certain related trusts and business entities).

Prohibited transactions themselves can include everything from buying or selling property between the IRA and a disqualified person, making the IRA assets available for a disqualified person’s use, or using IRA funds to compensate a disqualified person. Which is why it’s a prohibited transaction for an IRA owner to “fix up” a piece of IRA-owned real estate, or allow a family member to live in (for rent payments, or rent-free) property owned by the IRA, and even a financial advisor who earns a commission from selling an investment into a family member’s IRA can trigger a prohibited transaction (although level advisory fees are permitted). Similarly, an IRA owner must be caution not to pay any non-IRA investment management fees, or financial planning fees, using IRA assets (as the IRA should only pay its own advisory fees).

Fortunately, in the past the IRS has been fairly lax in pursuing and attempting to enforce against IRA prohibited transactions. But with the rise of self-directed IRAs buying real estate over the past decade, and more generally the popularity of using self-directed IRAs for “alternative” investments – which a recent GAO study estimates is now a $50B marketplace – there is a growing risk that the IRS will soon increase its enforcement on IRA prohibited transactions. Which means it’s crucial for IRA owners to take a careful look at how they’re using their IRA, especially for accounts that are not simply invested in “traditional” publicly traded securities… as even if a self-directed IRA provider affirms that it can hold a particular alternative investment, it’s still the legal responsibility of the IRA owner themselves to determine if it is permissible, and avoid triggering prohibited transactions!